vesting

Who Needs the Stock Market?

By Matt Bell for Sound Mind Investing

The Dow Jones Industrial Average plummets 635 points on Monday. The next day it soars 435 points. Then down another 520 on Wednesday, up 423 on Thursday, and the week comes to a merciful end with a 126-point Friday gain. Those are real numbers from one very scary week in mid-August 2011.

While the stock market isn't often that exciting, it isn't for the faint of heart. In fact, in order to invest in the stock market, it's best to check your heart at the door. But not your mind, because if you look at it logically, investing in the stock market actually makes sense.

Lessons from history

According to Vanguard, a bond-only portfolio would have generated average annual returns of 5.6% since 1926, versus 9.9% for a stock-only portfolio. But be warned: these average returns look better than they actually are. That's because inflation and taxes are relentlessly reducing the value of our investment dollars. Inflation has averaged roughly 3% per year over many decades, and while taxes are highly variable based on income and other factors, they reduce annual investment returns even further.

If you earn 5.6% from a bond portfolio, but surrender 3% to inflation and another percent or two to taxes, you haven't made nearly as much progress in terms of your actual buying power as it first appears. Only stocks have a long-term track record of significantly outpacing inflation and taxes.

Of course, it's important to recognize that these long-term averages are made up of many highs and lows. Since 1962, the stock market has averaged one correction of 10% or more roughly every other year. That makes stock market investing a "two steps forward, one step back" type of dance.

And as the recent past has illustrated, sometimes those backward steps are more like giant leaps.

Managing the risk

Because no one knows how the stock market will perform in the future, it's wise to mitigate that risk by making sure your portfolio is properly diversified. Numerous academic studies have shown that asset allocation accounts for the lion's share of your long-term investment results. (One study went so far as to say it can be traced to as much as 90% of the final outcome.) This fact surprises many people who assume, incorrectly, that choosing the right specific investments is the most important component of investing performance.

The starting point of asset allocation is choosing the proper balance between stock-based investments and bond-based investments. How you strike that balance impacts the results you can expect and how much volatility you're likely to experience along the way. The more your allocation leans toward stock-type investments, the more volatility you can expect, but also the higher your expected long-term rate of return. While many people might prefer to avoid the volatility of stocks, most can't afford to choose all bond-type investments. If they did, they'd miss out on the gains necessary to outpace inflation and taxes.

We recently compared the results and volatility across seven mutual fund portfolios, starting with a portfolio that invested only in the stocks of small-growth companies. Over a 24-year time period, it generated impressive 10.3% average annual returns. However, those returns came at a high cost: the volatility of this portfolio was 38% higher than the stock market as a whole.

Each subsequent portfolio was increasingly more diversified, with the final one spreading its investments across funds in five different stock-based asset classes while also including bonds and some inflation hedges such as gold and real estate. This portfolio generated still-impressive average annual returns of 9.1%, but with volatility 18% lower than the stock market.

Sticking with the stock market

So, who needs the stock market? Most investors. Typically only the oldest and most conservative investors should consider a 100% bond portfolio. For everyone else, including most retirees, we recommend at least some exposure to the stock market.

Assuming you've implemented an investment strategy based on an appropriate asset allocation, and assuming you're willing to stick with your strategy even when the market gets ugly, stocks remain your best hope of generating the investment returns you'll need in order to achieve your investment goals.

Matt Bell is the Associate Editor of Sound Mind Investing, the best-selling investment newsletter written from a biblical perspective. SMI wants people to have more so they can provide well for their families and generously support God’s work.

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